Sunday, September 27, 2009

Debit cards have become a popular alternative to credit cards because they have many of the conveniences of credit cards without actual debt. I have come to rely more and more on my debit card because I don't have to carry a checkbook and hold up checkout lines with identification hassles every time I write a check. I simply swipe the card and go on my way. Money is deducted directly from my checking account, just as if I wrote a check. Once I deplete my checking account balance, the card stays in my wallet until the next payday. It appears to be a full proof system for staying out of debt.

However, appearances can be deceiving because the belief that you can't get into debt using a debit card is based on a false assumption. Account holders naturally assume that once the balance is zero, transactions will be declined. The reality is banks will process the transaction even if the money is not in the account and then assess hefty overdraft fees. The account holder becomes liable for the purchase, the overdraft fee, and any additional fees that the bank dreams up.

My teenage daughter had a recent run-in with debit card fees. She does not have a credit card, but she has a checking account at M &T Bank with a debit/ATM card, and a job with direct deposit for her paychecks. Like many consumers, she believed that a debit card protected her from ever spending more than the balance in her account. However, a couple of small purchases during a night out with friends unleashed a cascading series of bank charges put the balance on her account hopelessly below zero.

At a local eatery she bought a sandwich for $8 and then moved across the street to the local coffee shop where she made a $4 purchase. She thought her checking account balance was low, but each transaction on her debit card was approved. What she didn't realize is that because she did not have the money to cover either purchase, each transaction triggered a $35 overdraft fee. Checking her account online the next day, revealed that she was now more than $70 below zero. She thought the problem would be solved in a few days when her paycheck for $90 would be posted.

However, that was another false assumption. M&T's fee structure imposed a $10 charge everyday that the account remained below zero. By the time the $90 arrived she was more than $100 in the red and counting. Her paycheck vanished and the $10 daily charges continued. The next $90 paycheck would be in two weeks. It had become mathematically impossible for her get out of debt.

After learning all this, I understand why payday loan operations continue to thrive despite their exorbitant fees. In some circumstances, a payday loan is a much better deal compared to a bank. For low-income people with small balances, a simple math error made while shopping can cause unrecoverable financial harm if a bank is involved.

Because my daughter wanted to be responsible for her own finances, she avoided telling me what was happening. I found out by accident, when coincidentally, another problem occurred with her account that prompted the bank to call, and I answered the phone. Someone had obtained access to her debit card number and was making fraudulent purchases. These transactions, totaling hundreds of dollars for purchases in places outside the United States, had not been declined either. But the bank's monitoring systems had flagged them as suspicious and called to verify their authenticity.

We had to visit the bank and fill out paperwork certifying that the transactions were indeed fraudulent so that the charges could be reversed. By the time we arrived, the fraudulent purchases, multiple overdraft fees, and daily charges had resulted in a checking account balance that was close to $1500 below zero.

I asked the M&T bank manager: "At what point does the balance get so far below zero that transactions are declined?" Interestingly, he did not have an exact answer to that question. He indicated that there are limits, but that the limits are not hard and fast. From his point-of-view, the bank was doing a favor by allowing purchases to go through even if no money was in the account to cover them. Of course, it is an unasked favor, for which the bank is charging fees that are often far greater than the purchase amounts in question.

On reflection, I found the bank's priorities deeply unsettling. After all, M&T had asked us to come in, but it was the suspicious pattern of activity that triggered the phone call, not the negative balance. A $4 purchase at a local coffee shop that resulted in hundreds of dollars in fees is part of the bank's business model. A $300 purchase for tickets to a Canadian amusement park that my daughter couldn't possibly have made, is a threat to the bank's business model. The latter event triggered a phone call from the bank; the former event did not concern them. The bank had no moral qualms about appropriating my daughter's entire paycheck for a $4 coffee purchase, but acted outraged by someone taking money from the bank.

After reversing all the fraud, we still had the negative balanced caused by the fees associated with the legitimate purchases. I managed to negotiate reversals for all but the first overdraft fee. That restored her account balance to a positive number and eliminated the daily $10 charges.

However, I found agreeing to even one overdraft fee a distasteful compromise given that my daughter never agreed to overdraft protection in the first place. In fact, not only do banks provide an expensive service that is not always wanted, but they also deceive customers further by re-ordering transactions to maximize fees. Suppose you went shopping with $100 in your account and made purchases of $4, $6, $8, and $102 in that order. You might think that the $102 purchase at the end would trigger a $35 overdraft fee because you had a large enough balance to cover the first three purchases. But, at the end of the day the bank would assess $140 in fees by re-ordering the purchases. It would process the largest purchase first as an overdraft, followed by the other three small purchases all as overdrafts.

These practices might be changing because Congress is debating new legislation that would require banks to get your permission before setting up your account with expensive overdraft protection. Consumers are also fighting back. Eileen Ambrose reported in The Baltimore Sun that Maxine Given of Baltimore County, sued M&T Bank, claiming the bank's overdraft program violates Maryland's consumer protection laws. And, as Bob Sullivan reported in his Red Tape Chronicles, consumers are leveraging the power of social media online to publicly embarrass and shame the shady practices of many banks. Let's hope Congress gets the message and enacts meaningful consumer protections.

Thursday, September 10, 2009

I am mystified by the arguments presented by opponents of the “public option” for health insurance. Their line of reasoning has a rather obvious logical flaw. The gist of the argument against the public option is that it would lead to a government take over of the entire health care system because private insurers couldn’t compete with the government. Opponents of the public option say that would be a bad outcome because government-run-health care would not be able to provide the kind of health care services people want and need. Their underlying assumption is that any health care plan run by the government would be an inferior product compared to private health insurance.

But, that assumption is the source of the logical flaw. Since when is it a competitive advantage to offer an inferior undesirable product? If public health care were really as bad as opponents claim, why would anyone choose it? It seems that the real fear opponents of the public option have is that many people might find it an attractive choice. But, if it’s an attractive choice, why is that a problem?

Actually the market place is full of examples where private, for-profit companies compete successfully against government-run or non-profit entities.

My job at a private college is not threatened by the existence of cheaper public schools.

Rural electric cooperatives are not a threat to for-profit electric companies because those companies do not find it profitable to serve the rural market.

Package delivery services provided by private companies such as UPS and FedEx compete successfully against the “public option” of the U. S. Postal Service.

The existence of member-run credit unions did not put private banks out of business.

In fact the banks managed to fail by themselves; no outside competition was needed. That fact calls into question the entire assumption that privately-owned equals competent and efficient while government-run equals inept and wasteful. To borrow the title of a recent book on the collapse of Lehman Brothers, “a colossal failure of common sense ” permeates the management of many privately run companies.

No organization, public or private, is immune from ineptness and mismanagement. But, if I worked for an organization that I perceived as incompetent, I would work to fix the problems or find another job. I would not contribute to the problems just to prove my point that the organization is dysfunctional. Unfortunately, many members of Congress work for the government solely to prove that government doesn't work.

Actually, private and non-profit health insurers already compete head-to-head in the marketplace. My health plan through my employer is with a non-profit company. Its existence hasn’t put the private for-profit health insurers in my state out of business. I fail to see how public health insurance for people not currently served can be a threat to the existing private insurance system.

No one has suggested that private insurance and private health care be outlawed. This being America, I have no doubt that those who have the jobs and income that provide adequate health care will continue to receive the kind of care to which they are accustomed. The issue is how do we as a nation provide care for the tens of millions of fellow citizens who are not served by the current system. Many of the uninsured have zero options available. Every other developed nation in the Western world takes care of its citizens. How can the richest nation of them all, claim it cannot afford to?

Friday, August 14, 2009

I just returned from a trip to the UK where I spent four days touring London and then four days at Cambridge University where I gave a talk about the mortgage crisis in the United States. It struck me perusing the London media just how many of the banking problems in the UK mirror those in the US and even more striking, how the rhetoric matches word-for-word.

A British tabloid-style newspaper—The Independent—ran a headline on August 4: ‘Big bonuses? It would be wrong to stop paying them.’ Beneath it ran the subheading: "Barclays’ £50m-a-year boss delivers a defiant rebuff to critics who say bankers are overpaid." Quotes in the article could have been lifted from the financial section of any newspaper in the US. Here is a sampling:

“performance-related bonus payments were vital given the bank's "obligation to run a client-first business”

“It is pay for performance and it is based on principles we have followed for a while now.”

“It would be wrong for the bank not to pay out ‘if we had really good performance.’”

And my favorite quote described seven-figure bonuses as:

“essential if we want people to work in our industry”

When I returned home, the first headline I saw in my local paper, the Baltimore Sun read: “CEOs paid more even as profits fall” followed by the subheading: “Debate swirls as most of the area's 10 top-earning CEOs receive higher compensation during a recession that has dragged down many companies' stock prices and profits.”

The reporters analyzed the compensation for 20 Baltimore-area companies that paid their CEO at least $1 million and found that 17 received compensation increases even though in most cases company profits fell. The reporters obtain their compensation figures from documents filed with the SEC. The company spokepersons who responded to questions couldn’t give the usual “pay for performance” justification without sounding completely out of touch with reality. Instead elaborate mathematical manipulations were offered to convince everyone that the figures for executive pay on SEC-required filings were misleading because of SEC-enforced rules. The spokespersons insisted that the pay the CEOs actually received was much lower. I don’t know if I should take comfort in the argument that federal law requires that SEC documents misrepresent actual pay.

It occurred to me as I read the articles in Baltimore and London that no matter what order of magnitude is attached to compensation figures, spokespersons for the industry will argue that it must be at that level. As the recession squeezes budgets, teachers with 5-figure incomes warn public education will suffer if salaries are cut, medical doctors making 6-figure incomes warn that public health will suffer if government-run healthcare puts limits on their income, and here we have bankers with 7-figure incomes arguing that banks will fail to function if CEO compensation is limited. It appears that compensation is like closet space, no matter how much you have, expenses will expand to require all of it. Any reduction in income then becomes unimaginable.

However, I find the logic for executive compensation interesting on many different levels. First it would be interesting to know if independent studies have found cause and effect relationships between executive pay and company performance. Recently I came across a study on the relationship between the cost of executive homes and company performance.

Two business professors, Crocker H. Liu and David Yermack, conducted a study reported in a paper titled: "Where are the Shareholders Mansions? CEOs Home Purchases, Stock Sales, and Subsequent Company Performance." The study found an inverse relationship between company performance and CEO stock sales to finance large real estate purchases. In other words the bigger the CEO’s home the worse the company performs. The authors concluded that, “regardless of the source of finance, future company performance deteriorates when CEOs acquire extremely large or costly mansions and estates.” It is wrong to generalize from a single study but it does suggest that the justifications for high executive compensation might not hold up when the facts are examined.

A large part of the problem as Jay Hancock pointed out in a recent column is that CEO pay is not negotiated with the company owners. Boards of directors determine CEO pay, not the shareholders who actually own the company. As a result market forces don’t work, an observation made by the father of free-market capitalist principles Adam Smith more than two centuries ago. It is worth reading the entire section below from Smith’s treatise The Wealth of Nations because it describes exactly the problems with executive pay today.

“The trade of a joint stock company is always managed by a court of directors. This court, indeed, is frequently subject, in many respects, to the control of a general court of proprietors. But the greater part of those proprietors seldom pretend to understand anything of the business of the company, and when the spirit of faction happens not to prevail among them, give themselves no trouble about it, but receive contentedly such half-yearly or yearly dividend as the directors think proper to make to them. This total exemption from trouble and from risk, beyond a limited sum, encourages many people to become adventurers in joint stock companies, who would, upon no account, hazard their fortunes in any private copartnery. Such companies, therefore, commonly draw to themselves much greater stocks than any private copartnery can boast of. The trading stock of the South Sea Company, at one time, amounted to upwards of thirty-three millions eight hundred thousand pounds. The divided capital of the Bank of England amounts, at present, to ten millions seven hundred and eighty thousand pounds. The directors of such companies, however, being the managers rather of other people's money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master's honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. It is upon this account that joint stock companies for foreign trade have seldom been able to maintain the competition against private adventurers. They have, accordingly, very seldom succeeded without an exclusive privilege, and frequently have not succeeded with one. Without an exclusive privilege they have commonly mismanaged the trade. With an exclusive privilege they have both mismanaged and confined it.”

Adam Smith understood that “negligence and profusion” would always prevail in the management of publicly traded companies because the directors are not the owners. Of course newspapers like to report on the excesses of high-living executives and print their self-serving explanations because of the public outrage stirred. There is an obvious “two-headed quarter” in play that angers people. Executives profit handsomely when performance is good and profit handsomely when performance is bad.

However, I see an attitude that is even more deeply troubling. Beyond the conflicts of interest Adam Smith described, the idea that seven-figure salaries are essential or there would be no executives might be a more revealing testament to the cause of dysfunction in corporate America.

For most people pay is a necessary condition to work but not sufficient. Motivating people to do a job well usually requires more than money. For many people work is an opportunity to perform a social good and contribute to a cause larger than oneself. Teachers teach and doctors practice for reasons beyond money.

But, the apologists for high executive pay, talk about compensation and performance only in monetary terms. This is an attitude that does a disservice to the majority of their own employees. When I go into my bank the people who work there seem genuine in wanting to help me. It is a social transaction, not just financial.

I am well aware that in any industry, compensation is determined by market forces that have more to do with scarcity than the value of the work to society. It is for those reasons major league baseball players will always make orders of magnitude more than teachers. But success in teaching and sports is usually defined in non-financial terms. To do the work requires a desire for more than just money.

The evaluation of executives needs to include more than just financial measures. There needs to be ethical and societal dimensions when evaluating the performance of executives because the decisions they make have impacts far beyond the company stock price. The underlying assumption behind performance evaluation—rising stock price equals good; falling stock price equals bad—is overly simplistic. When large companies fail many more people than the shareholders lose.

Thursday, July 16, 2009

An article in the Baltimore Sun this past week: “A Failing Grade for Maryland Math,” highlighted a problem that I believe is not unique to Maryland. The author, Liz Bowie, explained that the math taught in Maryland high schools is deemed insufficient by many colleges. More and more entering college students are required to take remedial math. In many cases incoming college students cannot do basic arithmetic even after passing all the high school math tests.

The article resonated with me because in recent years I’ve witnessed first hand the disconnect between high school and college math curricula. As a parent of three children with current ages 14, 17, and 20, I’ve done my share of tutoring of middle school and high school math. The problems assigned to my children have become progressively more difficult through the years to the point of being bizarre. My wife keeps shaking her head at how parents without my level of math expertise assist their children.

For example, my eighth-grade daughter asked me one evening how to perform “matrix inversions.” This is a technique I teach in a college sophomore-level mathematical methods course for physics majors. Matrix inversion is difficult for me to do off the top of my head. I needed to refresh my memory by referring to a highly advanced math book. Another night my daughter brought home a word problem that was easy for me to do with my advanced knowledge of differential equations but it took me a lot of thought to arrive at an explanation comprehensible to an eighth-grader.

My other daughter struggled through a high-school trigonometry course filled with problems that I might assign to my upper-class physics majors. I certainly wouldn’t assign problems at such a high level to college freshmen. I kept asking her how she was taught to do the problems. I wondered if the teacher knew special techniques unknown to me that made solving them much easier. Alas no such techniques ever materialized. The problems were as difficult as I judged. At least I could solve the problems, a feat the teacher couldn’t manage in a number of cases.

At the same time I work the summer orientation sessions at Loyola College registering incoming freshmen for classes. Time and again students cannot pass the placement exam for college calculus. Many students cannot pass the exam for pre-calculus and that saddles them with a non-credit remedial math course. Without the ability to take college-level math the choices students have for majors are severely limited. No college-level math course means not majoring in any of the sciences, engineering, computer, business, or social science programs.

A colleague in the engineering department complained to me that many students who wanted to major in engineering could not place into calculus. The engineering program is structured so that no calculus means no physics freshmen year and no physics means no engineering courses until it’s too late to complete the program in four years. For all practical purposes readiness for calculus as an entering freshmen determines choice of major and career. The math placement test given to incoming freshmen at orientation has much higher stakes than any test given in high school. But, the placement test has no course grade or teacher evaluation associated with it. No one but the student has any responsibility for its outcome.

So if eighth graders are taught math at the level of a college sophomore why are graduating seniors struggling? From my knowledge of both curricula I see three problems.

1. Confusing difficulty with rigor. It appears to me that the creators of the grade school math curricula believe that “rigor” means pushing students to do ever more difficult problems at a younger age. It’s like teaching difficult concerti to novice musicians before they master the basics of their instruments. Rigor—defined by the dictionary in the context of mathematics as a “scrupulous or inflexible accuracy”—is best obtained by learning age-appropriate concepts and techniques. Attempting difficult problems without the proper foundation is actually an impediment to developing rigor.

2. Mistaking process for understanding. Just because a student can perform a technique that solves a difficult problem doesn’t mean that he or she understands the problem. There is a delightful story recounted by Nobel-prize winning physicist Richard Feynman in his book Surely You're Joking, Mr.Feynman!: Adventures of a Curious Characterabout an arithmetic competition between him and an abacus salesman. (The incident happened in the 1950’s before the invention of calculators.) Here is the link to the full text of the story.

Feynman and the abacus salesman competed on who could do arithmetic faster. Feynman lost when the problems were simple addition. But he was very competitive at multiplication and won easily at the apparently impossible task of finding a cubed root. The salesman was totally bewildered by the outcome. How can Feynman have a comparative advantage at hard problems when he lags far behind at the easy ones? But when Feynman tried to explain his techniques he discovered the salesman had no understanding of arithmetic. All he does is move beads on an abacus. It was not possible for Feynman to teach the salesman additional mathematics because despite appearances he understood absolutely nothing.

This is the problem with teaching eight-graders techniques such as matrix inversion. The arithmetic steps can be memorized but it will be a long time, if ever, before the concept and motivation for the process is understood. That raises the question of what exactly is being accomplished with such a curricula? Learning techniques without understanding them does no good in preparing students for college. At the college level emphasis is on understanding, not memorization and computation prowess.

3. Teaching concepts that are developmentally inappropriate. Teaching advanced algebra in middle school pushes concepts on students that are beyond normal development at that age. Walking is not taught to six-month olds and reading is not taught to two-year olds because children are not developmentally ready at those ages for those skills. It is very difficult to short-cut development. All teachers dream of arriving at a crystal clear explanation of a concept that will cause an immediate “aha” moment for the student. But those flashes of insight cannot happen until the student is developmentally ready. Because math involves knowledge, skill and understanding of symbolic representations for abstract concepts it is extremely difficult to short cut development.

When I tutored my other daughter in seventh grade algebra, in her words she “found it creepy” that I knew how to do every single problem in her rather large textbook. When I related the remark to a fellow physicist he said: “But its algebra. There are only three or four things you have to know.” Yes, but it took me years of development before I understood there were only a few things you had to know to do algebra. I can’t tell my seventh grader or anyone else without the proper developmental background the few things you have to know for algebra and send them off to do every problem in the book.

All three of these problems are the result of the adult obsession with testing and the need to show year-to-year improvement in test scores. Age-appropriate development and understanding of mathematical concepts does not advance at a rate fast enough to please test-obsessed lawmakers. But adults using test scores to reward or punish other adults are doing a disservice to the children they claim to be helping.

It does not matter the exact age that you learned to walk. What matters is that you learned to walk at a developmentally appropriate time. To do my job as a physicist I need to know matrix inversion. It didn’t hurt my career that I learned that technique in college rather than in eighth grade. What mattered was that I understood enough about math when I got to college that I could take calculus. Memorizing a long list of advanced techniques to appease test scorers does not constitute an understanding.

Thursday, July 2, 2009

The news that the government is issuing stronger warnings about acetaminophen and possibly banning its use in some products is long overdue. Because of my own experiences, I have been mystified by perceptions of the safety of this drug for years. To me the medical community appeared as oblivious as the public.

Like most people, I believed acetaminophen to be very safe drug. In 2003 I had an illness with a high fever that continued for more than a week. I had never in my life, before or since, been so sick. The fever was so debilitating that to stay lucid I found myself taking the maximum recommended dose of acetaminophen each day. The chills and sweats came back as soon as each dose wore off and every six hours I popped more pills.

After a week elapsed with no improvement I went to see a doctor. He examined me and said that I appeared to have hepatitis. Blood work would be necessary to confirm the diagnosis. He drew the blood and sent me home.

How could I have hepatitis? I immediately started to read about the disease to learn more about the different types and causes. Hepatitis is a general term that refers to an inflammation of the liver. It is not a single disease because there are a number of causes of liver inflammation. If the condition continues untreated it can lead to liver failure.

After learning about the different viral causes of hepatitis I started reading about chemical causes. A number of drugs can inflame the liver but the most common drug-induced hepatitis is caused by acetaminophen.

Learning that fact caused the science part of my brain took over. What hypotheses can I form given the data and how can each be tested. I could construct two cause and effects narratives to fit the data.

1. I have hepatitis that caused a fever and in response I took acetaminophen.2. I have a fever that caused me to take acetaminophen and in response I developed hepatitis.

The doctor had jumped quickly to testing the first hypothesis. But, given my unlikely exposure to any viral form of the disease, it occurred to me that the second hypothesis was the most plausible. I stopped taking acetaminophen and in a few days the hepatitis symptoms went away. The doctor called back to say that I tested negative for all the viral forms of the disease. He never asked about acetaminophen or mentioned its use as a potential problem.

I eventually recovered from the illness. It took almost a month before I felt completely well. To this day I don’t know what I had. Most likely it was some random viral infection that it took my immune system a long time to eliminate.

A few months later I crossed paths with a colleague who I had not talked to in a while. We inquired about each other’s families and he told me about a health crisis with his adult son. He began a story with remarkable parallels to my own. His son had an unexplained fever that went on for more than a week. The doctors did not know the cause and advised him to take acetaminophen to control the fever. But then his son’s experience took a harrowing divergence from my own. Following the doctor’s advice he continued to take acetaminophen for the fever and found himself hospitalized with liver failure.

My colleague said to me: “We had no idea acetaminophen could cause liver failure. We thought it was safe drug because the doctors kept telling him to take it.”

The makers of acetaminophen products—Tylenol, Nyquil, etc.—insist the drugs are safe when used as directed. But, I am skeptical about directions that include just two dosage variations—adult and child. There must be more variation in acetaminophen tolerance within the adult population. A one size fits all number for the recommended dosage for adults does not make sense.

For example, I am an almost exactly average adult male—5-feet 10-inches, 185 pounds, right-handed. That means almost all personal products—furniture, cars, homes, etc. and yes, drug dosages—are designed for me. All other people have to make adjustments when they use these products because I’m the person everything is designed for.

But, the dosing instructions for acetaminophen are too much for me to metabolize. Does that mean I have a less than average tolerance for the drug? How many other people are like me? What about the female half of the population? The current dosage instructions address none of these questions. Given the dangers of acetaminophen those questions should be addressed and the government is right to require warnings.

The most important lesson I learned from my experience is to ask these questions early and do independent research. Do not blindly follow dosing instructions on a package or follow “expert” advice from doctors who cannot think through all the possibilities in the short 10-minutes they allot for an exam. It took me some time and effort to figure out what was happening but the insights saved me from potentially dangerous complications.

Saturday, June 13, 2009

The announcement by the school where I teach, Loyola College, that it would no longer require SAT scores for applicants brought a vitriolic response from recent alumni that the Baltimore Sun published. That opinion piece generated a heated discussion on blogs that the Baltimore Sun published two days later.

I found deeply troubling the arguments made by the alumni for keeping the SAT requirement at Loyola and the tone of their reaction to the news disturbing. The assertion made in the opinion piece that making SAT’s optional for admission will “financially depreciate” the bachelor's degrees granted by Loyola is based on two underlying assumptions that are false.

First, admission to Loyola is not a guarantee of a degree from Loyola. Students have to do the work required to earn the degree. Admission standards should not be confused with academic standards. I am never told the SAT scores, high school grades, or any of the reasons the Loyola admitted the students in my classes. Honestly, I am not interested in any of that information.

I teach my subject to the students enrolled in the class and assigned grades based on performance expectations that have not changed throughout my career. SAT scores have no bearing on the criteria I have established for passing my courses.

I also serve on Loyola’s academic standards committee. At the end of each semester that committee is charged with reviewing student grades and dismissing any students who are not making satisfactory progress towards a degree. Again it is grades earned at Loyola that are reviewed, not the reasons the students were admitted. SAT scores have never entered into these discussions.

Second, college degrees have no “financial value” so it is not possible for them to “depreciate.” A degree is a non-transferable status that cannot be bought or sold. I know this seems like a strange assertion given the wide disparity between the average lifetime earnings of college graduates compared to those without college degrees. But students are mistaken if they believe that degrees are the cause of the higher income typically earned by college graduates.

No employer pays a person because he or she has a college degree. Employees are paid for the performance of work if it has sufficient value that it becomes in the financial best interest of the employer to pay. It happens that the knowledge, skills, and insights that are acquired through the process of obtaining a college degree often results in the ability to perform work that is of greater value to employers. But there are people without degrees who are highly paid because they perform valuable work. It is work that causes payment, not the abilities associated with the degree. Graduates who cannot establish themselves as productive workers will find that their degrees mean very little financially.

So do I think Loyola should become an SAT-optional school? I am in agreement with the new policy. I find the entire concept of “scholastic aptitude” that the SAT purports to measure suspect. Readiness for college depends on acquiring the necessary language, writing, and math skills necessary for college-level work. These are not “aptitudes” that a single test can measure, rather, these are skills acquired through study and practice.

Once in college success is more dependent on attitude than aptitude. Students will do well if they attend class, do the assigned work, and major in a subject that interests them. That sounds simple and trite, but my experience on the Academic Standards Committee has revealed that students who fail in college haven’t mastered those basic practices.

SAT scores were meant to provide a level playing field for college admission by putting students from all backgrounds on equal footing. But, as it usually happens when a number is substituted for judgment, inordinate amounts of time, effort, and expense are allocated toward manipulating the number. Witness the entire test preparation industry that has grown up because of the SAT. Spending thousands of dollars on SAT prep classes defeats the original purpose of a level playing field. It’s time to retire the number.

For recent graduates entering the workforce, college reputation and courses of study are important because it is all employers have as a basis for judging competence and abilities. But within four to five years of graduation it will be performance on the job that counts. For me it has now been 32 years since I entered college and 28 since I graduated. I no longer remember my SAT scores and if my alma mater, the University of Rochester, changes its SAT policy there would be no impact on my life—financial or otherwise.

Friday, April 10, 2009

The failures of large investment and insurance houses—Bear Sterns, Lehman Brothers, AIG, Freddie Mac, Fannie Mae—demonstrate that the models these companies used to manage risk were deeply flawed. The defense offered by many on Wall Street is that market events of the past year have been so extreme, so far from the norm, no one could have predicted or planned for such as financial catastrophe. Repeatedly financial and political leaders have compared the past year to events of the Great Depression. It appears that the risk models failed because market contractions of the current magnitude were not considered a possibility.

Extreme events by definition have low probabilities of occurrence. But low probability does not equal zero probability. Was it reasonable for the financial analysts to consider current events in the markets so far outside the norm that they would not occur? I keep hearing that current market conditions are not normal. But, in reflecting back over the past few decades I’m hard-pressed to think of any time that was “normal.”

During the mid-1990s stocks increased so fast that investors not making 20% per year felt left out of the boom. At the beginning the bull market in 1995 the Standard and Poors 500 index increased 34% in that year alone. From 1995 to 1999 it had returns in excess of 19% for each of those 5 years, more than doubling its overall value. Plenty of warnings were sounded that those market conditions were not normal and would not last. The crash at the end of the decade revealed that many companies simply made up numbers on earnings reports to drive the increase in stock prices. High-flying companies of the 1990s such as Enron, Global Crossing, Worldcom became synonyms for fraud and a number of their top executives are still in prison.

The recession of 1991-92 was so deep it cost President George H. W. Bush his job. Despite winning a popular war, he was unseated by Bill Clinton’s laser-like focus on economic problems. Everyone remembers “The economy, stupid” sign hung at his campaign headquarters.

In 1987 the stock market lost 25% of its value on a single trading day. At today’s valuation levels that would be the equivalent of a one-day drop of 2000-points.

During the mid-1980s certificate of deposits paid double-digit interest rates. I remember owning a one-year certificate of deposit that paid 10% annual interest. I also remember a life insurance salesman running a projection on the future value of a whole life policy that he was trying to sell me. Based on just small premiums (about $100 per month) he calculated an impressive future value of over a million dollars by the time I would retire in 40 years. Of course his calculation assumed an annual interest rate of 12% in perpetuity—a laughable projection given that annual rates on money market balances today are less than 1%.

The recession of 1981-82 resulted in unemployment greater than 10%, a rate we have yet to reach in the current recession.

I could extend this list of extreme economic events and conditions indefinitely back in time. But, the above reflection on events over the past 30 years shows that it is a fallacy to believe extreme events are outside of the “norm” and unlikely to happen. Instead it is apparent that extreme events are the norm. History is not going to stop and economic conditions, whether part of a boom or bust, never continue indefinitely.

But, I have noticed a tendency for financial planners and prognosticators to assume that economic conditions of the moment—whatever conditions are at that moment—will continue indefinitely. Much of the financial advice on buying, financing, and investing in homes over the past decade was all based on the assumption that prices in the housing market would only go up. This belief mirrors beliefs in the mid-1990s that stocks could only go up. The same thinking led my life insurance salesman in the mid-1980s to argue that interest rates on savings would be in the double digits forever.

The future is always uncertain and psychologists who study how people make decisions under uncertainty have identified a long list of “cognitive biases.” A bias refers to a repeated and predictable flaw in judgment that results in making less than optimal choices. For example, if you don’t know the future, optimal choice requires acting on the basis of the most probable outcomes. But the “neglect of probability bias" results in instances where people disregard probabilities when considering future outcomes.

Failure to use seat belts is an example of the neglect of probability bias. Car crashes are low probability events. You can drive for years, even decades and never be in a car crash. But, because the probability of crashing a car is not zero and consequence of even one crash potentially catastrophic, seat belts should be worn. The fact is car cashes occur with a rate predictable enough that auto insurance companies remain financially solvent. Evidently it is not that difficult to correctly price auto insurance.

Executives in banking and investing should consider devising something akin to a “financial seatbelt.” Rather than assume market crashes are too far outside the norm to worry about, they should accept the fact that market crashes have happened in the past and will happen in the future. They should have restraints in place ahead of time to limit the damage.

Tuesday, March 17, 2009

The confrontation between John Stewart and Jim Cramer last week illustrated just how upside down and surreal the U. S. media has become. The Stewart versus Cramer dust-up actually started when Rick Santelli of CNBC made an on the air rant blasting the Obama administration’s proposal to help homeowners facing foreclosure. Santelli said in his tirade “the government is promoting bad behavior,” and referred to homeowners facing foreclosure as “losers.”

In response Stewart ran a montage of clips showcasing consistently wrong CNBC financial predictions over the past year. The “experts” at CNBC urged viewers to buy the stocks of Bear Sterns,Lehman Brothers, Merrill Lynch, and AIG, in the months before these companies imploded. A particularly embarrassing clip showed Jim Cramer on CNBC recommending Bear Stearns as a buy just weeks before the company went under.

Stewart’s point is that if the “experts” dispensing advice are so completely wrong about the future, how are average homebuyers suppose to know the future? After all, many of the “loser” homeowners went broke taking advice from “experts” like Santelli and his ilk in the financial services industry.

The feud reached a climax last Thursday night when Cramer appeared as a guest on Stewart’s show. Stewart conducted a pointed interrogation interspersed with previously unaired video clips from December 2006 of Cramer explaining to someone how to make money from short positions by spreading rumors about companies. Referring to the video, Stewart said: “I want the Jim Cramer on CNBC to protect me from that Jim Cramer.”

Cramer defended himself by claiming that the CEOs of the companies he recommended lied to him. When Stewart suggested that he not take at face value what CEOs say Cramer responded with a bizarre defense. He said: “I’m not Eric Sevareid. I’m not Edward R. Morrow. I’m a guy trying to do an entertainment show about business for people to watch.”

At this point in the interview I realized what has gone so wrong in the media. The irony of this exchange is breath taking.

John Stewart bills himself as a comedian and works for a network called Comedy Central. His show—The Daily Show—is presented as a spoof of network news broadcast. Jim Cramer bills himself as a financial news reporter and works for a news network CNBC. His show—Mad Money—is promoted as serious financial analysis and investment advice.

But, when Cramer shows up as guest on Stewart’s comedy show, he is bombarded with tough, pointed, serious, questions about the soundness and ethics of the advice he dispenses. Cramer defends himself by asserting that he needs to entertain an audience that would tune out if his talk became too technical.

So a comedian is asking relevant questions while a news reporter pleads that he doesn’t ask questions because he needs to entertain. Has the world gone completely upside down? If I want real news reporting I need to watch “fake” news on the comedy channel. The “real” news people are too busy entertaining to do actual investigative reporting.

The over arching point that Stewart stressed throughout the 15-minute interview with Cramer, is that the financial reporters at CNBC are not fulfilling their responsibilities as journalists. The role of a free press is to investigate and question those in authority, not simply serve as a mouthpiece.

Much has been made of the failure of the regulatory agencies such as the SEC in the current financial meltdown. But where was the press while all of this was happening? Bernie Madoff ran a $50 billion Ponzi scheme for more than a decade while a financial analyst sent warning letters to the SEC that were ignored. No one at CNBC bothered to investigate and ask questions.

No reporter investigated or questioned AIG issuing more credit default swaps than it could ever possibly payout on. Bear Sterns, Lehman Brothers, and Merrill Lynch all used massive amounts of leverage, in some cases more than 30 to 1, to artificially inflate their investment returns—a reckless strategy that again no reporter questioned. Instead stocks in these investment firms were touted as good buys.

While all of this was happening the reporters at CNBC were concerned about “entertaining” their viewers. Stewart said: “I understand that you want to make finance entertaining, but it’s not a fucking game.”

No it’s not a game. Real money and real livelihoods are on the line. Real hard-earned wages went into now decimated 401k and pension plans. Real tax dollars are being spent to hold off collapse of the financial system.

I believe that if the financial reporters would do their jobs they would find criminal culpability on the part of many of the executives who ran these failed companies. I don’t believe that a blow up of the entire financial system to the tune of a trillion dollars happened without actual fraud taking place. With dollar amounts that large it should not have been that hard for the so-called “experts” to figure out what was going on.

Much has been made of the need for more oversight and regulation in the financial services sector. But, the government needs to take a hard look at possible criminal violation of regulations already in place. And the journalists need to get back to holding the government and CEOs accountable by investigating and asking questions. Leave the entertaining for the comedians.

Tuesday, March 10, 2009

After all the carnage in the mortgage industry over the past few years, I am still amazed that many in the financial services industry still do not understand the number gimmicks that led to the mess. An op-ed piece published in the February 27, 2009 Baltimore Sun by Sim B. Sitkin a professor of management at Duke University, advocated extending mortgages to 50 or even 100 years as a way to make houses more “affordable.” That sounds like an impressive proposal for lowering monthly payments. However, whether the mortgage term is for 50, 100 or even 1000 years, monthly payments can never fall to an amount less than the interest due on the first month of the loan. In the limit of extremely long loan terms, the loan effectively becomes an interest-only agreement.

Of course Mr. Sitkin didn’t use "interest-only" as a descriptor. That label now has a negative connotation given the millions of homeowners with interest-only loans currently underwater because home prices went down while their debt did not. But lets look at how much 50 and 100-year loans differ from interest only loans. I’ve constructed tables below with some examples. Scroll down to view the tables.

30-Year $200,000 loan

5%

7%

9%

Monthly Payment

$1073

$1330

$1609

Interest paid in the first month

$833

$1166

$1500

Principal paid in the first month

$240

$164

$109

Time to pay 10% of loan (years)

6

7.7

9.6

50-Year $200,000 loan

5%

7%

9%

Monthly Payment

$908

$1203

$1517

Interest paid in the first month

$833

$1166

$1500

Principal paid in the first month

$75

$37

$17

Time to pay 10% of loan (years)

15

20.5

25.4

100-Year $200,000 loan

5%

7%

9%

Monthly Payment

$839.04

$1167.75

$1500.19

Interest paid in the first month

$833.33

$1166.66

$1500

Principal paid in the first month

$5.71

$1.09

$0.19

Time to pay 10% of loan (years)

55

67.2

74.4

Here are some numerical facts from these tables.

First note that a 100-year mortgage proposed by Mr. Sitkin is for all practical purposes an interest-only loan. No significant debt reduction will take place in the borrower’s lifetime.

Second any advantages that a 50-year loan would have over a 30-year loan in reducing monthly payments diminishes at higher interest rates. The difference in monthly payments been a 30-year and 50-year mortgage decreases as interest rates increase. Also the amount allocated towards principal in the early years of the mortgage becomes less for both 30 and 50-year loans at higher interest rates.

Mr. Sitkin used 5% as an example interest rate. However, I pointed out in a letter to the editor that the Baltimore Sun published that “to get a lender to commit to so long a loan would probably require paying a higher rate than the historically low 5 percent mortgage rate used in the example. In that case, the numbers get much worse for the borrower.”

My published letter provoked a response from Mr. Richard T. Webb, CEO of Atlantic Financial Federal Credit Union, that the Baltimore Sun published on March 8. In his letter he made two statements I find puzzling. In response to my assertion that interest rates would be higher for a 50-year loan compared to a 30-year loan he wrote:

“And from the point of view of the lending institution, I'd rather own a long-term 5 percent loan than have a bankruptcy judge cram down a mortgage payment.”

This prompted me to check the loan rate page on his credit union’s Website. I found the same pattern for interest rates on that page that I find at every other financial institution—the longer the loan’s term the high the interest rate. On the Baltimore Sun’sbusiness page today, the average rate for 15-year mortgages rate is 4.76% and for 30-year mortgages 5.17%. Although those numbers fluctuate daily, every single day the 30-year rate is greater than the 15-year rate. I have no reason to believe that the pattern of higher rates for longer loans would not continue for loan terms beyond 30 years.

The other puzzling assertion he made is that I failed “to consider the length of time most homeowners keep a mortgage.” He wrote:

“It's highly unusual for a homeowner to keep a mortgage for 30 years. The average time a mortgage is held is around seven to nine years. Extending the repayment period would achieve the desired effect of reducing the monthly mortgage payment. Wouldn't it make sense to be making smaller payments on a longer-term loan when the chances of staying in a house for 30 years are small?”

But isn’t that the reason why a homebuyer should avoid a 50-year loan? Again look at the numbers in my table above. Homebuyers who don’t pay down debt are at the whim of the market when it comes to refinancing or selling. If home prices rise they can sell or refinance. But, if prices fall homeowners have negative equity. No bank or lending institution will finance a home with negative equity. If rates fall, homeowners cannot refinance to take advantage of the lower rate for homes with negative equity.

Events of the past few years have shown that the assumption that home prices can only rise over time is false. But financial institutions are still dispensing advice based on that underlying assumption.

I still stand by my concluding paragraph in my letter to the Sun. Focusing only on monthly payments with no long-term plan for paying down the debt is one of the root causes of the housing crisis. Homebuyers would be better served with monthly payments that allow them to build equity, even if it means scaling down or deferring their homebuying choices.

Saturday, February 28, 2009

My previous post on Chase Credit Card Services reneging on agreements for low promotional rates prompted several comments, including one from a Chase employee. The comment from the Chase employee is very telling about the mindset of the credit card industry both for what it says and what it doesn’t say. That person wrote:

“I work for Chase Credit Card Services and thought I should inform you that we didn't just announce these Changes in Terms last week. We actually sent notifications to effected card members back in November, so they were informed 45-60 days in advance. If you are going to writing an article from a negative standpoint and try to preach to other people, at least make sure you have your facts straight.”

The commenter is correcting my use of the phrase “last week” twice in my February 16, 2009 post to set the timeline of events. I meant “last week” to refer to the publication of the newspaper articles I cited about Chase’s change to its credit card terms. Instead I made it sound that Chase changed its terms the week prior. Had I published the post in November it would have been correct. I should have used the ambiguous word “recently” which would have left wiggle room in setting the timeline.

This comment is telling in that it doesn’t address the question posed in my post: Whose lifetime was referenced when Chase offered a “lifetime” rate on a balance? As another commenter pointed out:

“If they gave 45 days notice, or just two, it's still false advertising, and a violation of the Truth In Lending Act: the terms of the loan were ‘fixed for the life of the loan.’ ”

But the mindset of the Chase employee is that the credit card agreement allows Chase to change the loan terms at any time, for any reason, as long as a minimum of 30 days notice is given. I believe that is why my use of the phrase “last week” stirred outrage. My usage implied more than 30 days noticed had not been given—a time period I regard as immaterial but to Chase is the only obligation they have under the terms of the agreement.

Like a magician—and many political and corporate leaders—the comment from the Chase employee uses misdirection. Their actions are to holler loud and long about minutiae and hope nobody notices what is actually happening.

As Dr. Robert Lahm commented:

“Imagine that, a company that has previously testified before Congress about playing fair and providing "opt outs" (none exists in this instance) correcting you in getting ‘facts straight.’ ”

Dr. Lahm has set up a protest/advocacy Website http://www.changeinterms.com to organize consumers to fight against abusive credit card practices. I applaud his efforts to call on Congress to force some semblance of fairness in credit card agreements.

Financial services companies are on the brink of collapse and many blame their failures on consumers. From the point-of-view of financial service providers, consumers spent too much, took out loans they could not afford, and were irresponsible in their use of credit. But, now Chase is disclosing that hundreds of thousands of its customers made rational decisions about credit and honored the terms of the agreement. These customers astutely saw that Chase offered them a loan with a favorable interest rate, borrowed the money and kept up payments under the terms of the loan agreement. Aren’t those the kind of informed, rational, financially responsible customers a credit card company desires? Apparently not.

I have a suggestion for Chase and all the other credit providers. Cut the enticements, the teaser rates, the cash back, the bonus points, the coupons, the gift cards, the air miles, the gasoline credits, the weekly bulk mailings, and all the other gimmicks. Offer consumers a credit card with a reasonable rate interest rate (less than 10%), a credit limit commensurate with income and credit history, and terms of use of that are fair to both parties. Events of the past year have demonstrated that the current business model for credit cards benefits no one.

Monday, February 16, 2009

The announcement last week from JP Morgan-Chase that some customers would be assessed fees on promotional credit card rates reminded me of a line from former St. Louis Cardinals baseball manager Whitey Herzog. It was back in the mid-1980s when the Cardinals were one of the top teams in baseball and Herzog widely lauded for his managerial skills. Gussie Busch, principal owner of the Cardinals and the Anheuser-Busch brewery offered Herzog a “lifetime appointment” as manager. Herzog’s response to the frail man well into his 80s: “Whose lifetime are we talking about?”

A valid question that looking back over the intervening 25 years was prescient. Gussie Busch died in 1989, Herzog is still alive today but quit managing the Cardinals in 1990, Anheuser-Busch sold the Cardinals in 1996, and in 2008 Anheuser-Busch itself was sold to the European conglomerate InBev.

What does this have to do with credit card fees? In recent years Chase credit card services has offered cash advances at low promotional rates under 5% to its credit card customers that promised the low rate for the “lifetime” of the balance. But, it happens that a “lifetime” for a typical customer is a long time on Wall Street where executives have trouble thinking beyond the end of the current quarter.

Chase now regards as problem customers those who took the bait but not the hook. Hundreds of thousands of customers thought “lifetime” referred to their longevity and have been in no hurry to pay back borrowed funds that accrue low finance charges. Chase never specified what it meant by “lifetime” in its promotional brochure and is now in the process of defining that time period as something considerable less than the numbers found in the actuarial tables for life expectancy.

Last week Chase announced that it would begin charging monthly “fees” to customers carrying balances with low promotional rates. Just how a “fee” differs from a “finance charge” has always been a mystery to me. To me money is money, but for Chase its new flat $10 per month fee is not a finance charge because it doesn’t use the same mathematical formula that it uses to compute finance charges. However, customers who called to complain about the monthly fee were told they could opt out of paying it if they would agree to pay a higher interest rate on the promotional balance.

Chase also changed the minimum monthly payment for these same customers from 2% of the balance to 5% of the balance. That means someone with a $10,000 balance will now need $500 to make the monthly payment instead of $200. Of course failure to make the minimum monthly payment on time results in forfeiture of the promotional rate and a default rate in excess of 25% immediately kicks in.

A spokeswoman for Chase, Stephanie Johnson, explained that the change only affects consumers with low promotional rates who have carried a large balance for more than two years and made little progress paying it off. So Chase’s answer to Whitey Herzog’s question is that “lifetime” means two years. Maybe Chase should only market promotional rates to customers in their late 90s.

A New York-base law firm, Giskan Solotaroff Anderson & Stewart, has brought a class-action lawsuit against Chase for changing the terms of the agreement. The terms of the promotional rate never disclosed that a $10 service fee would be applied after two years. It will be interesting to see how the lawsuit plays out. Most credit card agreements allow banks to unilaterally change the terms for any reason at any time. The agreements also require customers to waive their right to sue and must submit disputes to binding arbitration. I’ve always wondered if agreements with these kinds of provisions meet the legal definition of a contract. Hopefully this lawsuit will test the legality of bait and switch credit card agreements in a court of law.

By the way, JP Morgan Chase received over $25 billion in bailout money from taxpayers last year.

Tuesday, February 10, 2009

The scrutiny of Peanut Corporation of America’s food safety practices is uncovering more problems and forcing closures of more plants. This week a second plant in Texas was forced to shut down.

An infuriating revelation from this fiasco is that Peanut Corporation failed to tell inspectors that samples from its Georgia plant had tested positive for salmonella in 2007 and 2008. The company continued to sell products after having a second set of tests performed by another lab that came back negative.

It makes sense to repeat tests that reveal potentially expensive problems. For example, patients are counseled to seek second opinions before agreeing to expensive and invasive medical procedures. But interpreting secondary tests, particularly ones that conflict with earlier tests, requires care.

Managers of the peanut processing plant are right to conclude that a single positive test doesn’t provide conclusive proof that salmonella is a problem. But, that same reasoning also means that a single negative test doesn’t provide conclusive proof that the product is safe. Tests need to be repeated and more importantly, conflicting results need to be understood. Choosing to believe the test that provides the most convenient result is a recipe for disaster.

Test shopping has led to other expensive high-profile disasters. When the main mirror for the Hubble telescope was manufactured, preliminary tests showed that the mirror did not meet specifications and suffered from an optical flaw known as “spherical aberration.” But much more elaborate and much more expensive tests showed that the mirror had no abnormalities. Managers of the project reasoned that precision and expense must mean results that are more accurate and reliable. Unfortunately this is faulty reasoning. When tests give conflicting results there must be underlying reasons. A test that is designed to be more precise can still be performed improperly.

Rather than seek to understand why the test results conflicted, the mirror was approved for launch. When the first images came back so blurred as to be unusable, astronomers immediately knew the problem—spherical aberration. An expensive optical corrective system had to be designed and a space shuttle launched to install it, before the Hubble could provide usable images.

The lesson is that test results do not make something true. If peanut plant conditions are conducive to the growth of salmonella, the microbes are probably present whether the tests come back positive or negative. Testing cannot be a substitute for actual sanitation.

It’s of course easy for managers to fool themselves with wishful thinking. It’s easy to fool health inspectors and the public with “certified” test results conducted according to “standard” procedures that meet all the legal requirements. But the corporations, government officials, and public, should all be mindful of Richard Feynman’s famous last sentence in a report on an earlier deadly debacle—the space shuttle Challenger disaster. That failure stemmed from the same underlying cause—managers choosing what to believe rather than understand the reasons for the conflicts.

Feynman wrote: “For a successful technology, reality must take precedence over public relations, for nature cannot be fooled.”

Saturday, January 31, 2009

I have written about the practice of re-labeling expenditures with a different, nicer sounding name. Financial service companies are masters at this practice. Want to advertise an eye-catching low interest rate. Use a different word for the finance charges. Labels such as: transaction fee, points, rebate, origination fee, can all be used as reasons take money from consumers without using the emotionally charged label “interest.”

Given that financial institutions are masters at re-labeling, I am completely mystified by their use of the word “bonus” in labeling parts of employee compensation. This past week John Thain was fired when it became public that the day before his failed company, Merrill Lynch, was taken over by Bank of America he dispensed over $4 billion in bonuses. At the same time, the full extent of liabilities Bank of America had assumed was not fully disclosed. Probably because no one really knows just how much bad debt Merrill Lynch owned. Bank of America, after discovering that it had acquired a deeper and possibly bottomless money pit than it previously thought, was forced to go back to the government and plead for more bailout money.

Meanwhile a report that total year-end bonuses on Wall Street exceeded $18 billion brought a rare public display of anger from President Obama and promises to rein in Wall Street compensation packages. The practice of executives rewarding themselves while their companies and clients are ruined is described succinctly in a Forbes Magazine piece titled “Five Legal Scams” by William Baldwin. One scam labeled “Heads I win” is this: “Be a hedge fund manager. Pocket 20% of the gains if you are lucky, but chip in for none of the losses if you aren't.”

Executives on Wall Street defend bonuses as being performance-based and necessary to attract top financial talent. Which makes me wonder why they haven’t re-labeled “bonuses” with the word “commission.” From their defense of the practice its sounds to me that the kind of compensation they are describing is known as a “commission” in most other industries. The public might wonder why anyone would pay for the kind of “performance” and “talent” that created the mess on Wall Street. But, if a car dealership went belly-up no one would dispute that the salespeople should still receive their commissions.

However, the fact that it has never occurred to these executives to use the word “commission” is a telling statement about the kinds of products they sell. Auto salespeople are paid commissions for selling a tangible product. Each car manufactured has a vehicle identification number that is recorded and tracked by the manufacturer, dealership, state government, insurance company, lien holder and owner. As cars arrive and leave the lot it is nearly impossible to fake selling them. It is difficult for dealers to simply make up sales figures.

For financial services firms, making up numbers to describe profits and losses is easily doable. As the financial system unravels it is apparent that many firms did make up numbers. The fact that someone like Bernie Madoff could get away with a $50 billion Ponzi scheme for more than a decade is telling about the lack of real accountability in the financial services sector.

Perhaps instead of a different label executives should rethink their compensation packages and incentives. As it stands now, workers and managers have an incentive to “game” the system. I have written in my book, The Two Headed Quarter, about what I call “The Numerical Outcome Principle.” Once a number is used to judge outcomes, people will adjust their behavior to maximize that particular number. The actual outcome no longer matters. Because numbers are so fluid on Wall Street that is exactly what happened.

Tuesday, January 20, 2009

One of the difficult problems in experimental science is drawing conclusions from a null experiment. Suppose a theory forbids an event to happen—faster than light travel for example is forbidden by the theory of relativity. Looking for faster than light travel and not succeeding is a result consistent with the theory. But, the result doesn’t “prove” the theory. Your experiment might not have looked for faster than light travel in the right way, in the right place, or at the right time. You could spend a lifetime looking for an event that shouldn’t happen, not see any examples, and still not know for sure if the event could never happen.

Contrast that situation with an affirmative experiment. For example relativity predicts the bending of light by gravity. Einstein became famous after astronomer observed the bending of starlight as it passed by the sun. That affirmative result doesn’t “prove” the theory either, but at least you know light bending by gravity is a real effect. You don’t have to keep looking.

I was thinking about the problem with the null experiment this week because it arises in the current debate about the effectiveness of the government bailout of the financial industry. This past September congressional leaders and President Bush predicted imminent collapse of the United States’ financial system unless a $700 billion bailout plan passed. On September 29, 2008 the House of Representative rejected the proposal and the markets responded with a 777-point loss in the Dow. It closed at the end of that day at 10365.

The economic catastrophe theory appeared to be confirmed. House members quickly saw the error of their ways and within days a new version—containing additional pork to assuage some hurt feelings—passed into law. So did the bailout work? Was financial disaster averted?

In the three and half months since its passage the Dow has fallen another 2000 points and is now near 8000. The unemployment rate rose from 6.2% in September to 7.2% at the end of December. Major banks such as Citigroup are still teetering on edge of collapse and asking for more government money. Had the federal government not passed a bailout bill in October these events would be cited as the predicted catastrophe. But, because the government did pass the bailout bill a different interpretation is needed. Advocates, including Henry Paulson, have argued that without the bailout the economy could be much worse.

Which brings us back to the problem of the null experiment. Would it ever be possible to conclude that the bailout hasn’t worked? As long as the Dow remains above zero and the unemployment rate less than 100% it will always be possible to say the economy could be worse. But just because a total economic collapse has not happened doesn’t mean the theory that the bailout worked has been proved. Saying that the bailout prevented a total economic collapse because a total collapse was not observed is faulty logic. Taxpayers could feed money to banks forever on the basis of that reasoning.

It’s time for treasury officials to devise some affirmative experiments. The needs are for actions designed to produce positive economic effects that can be observed and measured. Only then will we know if the money has been productively spent.

Tuesday, January 13, 2009

The question asked repeatedly since the exposure of the Bernie Madoff fraud: How could so many smart money-savvy people be fooled for so long? What I find especially troubling is that the answer to that question is mundane. The techniques for enticing investors into a Ponzi scheme are timeless and trite.

Early in my adult life, a "buyer's club" enticed my wife and I to visit. A salesman subjected us to a high-pressure pitch to join. The proposition was that for a $1000 one-time membership fee, a lifetime of “savings” totaling hundreds of thousands of dollars would be ours. Everything we would ever need—appliances, furniture, electronics, even cars—would be available to us at greatly reduced prices.

Of course the offer came with conditions. The invitation to join the club was exclusive and would not be repeated. Although, the price would be reduced if we “nominated” friends and family for membership. All merchandise ordered had to be prepaid and members were responsible for the shipping costs. The catalogs detailing the merchandise and actual prices were kept secret and would not be revealed until we joined. The salesman explained that if it became widely known just how low club prices were no one would shop in a retail store again. The local economy would collapse. The reason that these fantastic discounts were available is that the club profited only from membership fees, not from merchandise sales.

The last statement tipped me that this was a Ponzi scheme and I walked out. If the club profited only from membership sales that would mean that as soon as the club sold all the memberships possible it would fold. The “lifetime” membership referred to the club’s lifetime, not mine. Besides there is no reason to believe that I am special, that my money is special, or that my friends and family should be granted special buying rights denied to others. In my book The Two Headed Quarter I call this line of reasoning the “mediocrity assumption.” As much as I would like to believe that my circumstances and opportunities are special and unique, they are not. Any salesperson trying to convince me otherwise is lying.

In reading about Madoff, I am struck by all the parallels to my buyer’s club experience. The aura of exclusiveness he created, the network of friends and families, the secrecy about what he did, and most striking—that he did not charge for his services—all telltale signs of a Ponzi scheme. But, he preyed on the wealthy and famous so that it was much easier to convince his marks that they were special. I think the scam would have failed with ordinary investors who know that they are not special. Madoff knew, that ironically, those most likely to fall for his scheme would be the kind of people thought least likely to be taken in by a such a scam.

Of course in the end Ponzi schemes fail because of the math. Security analyst and graduate of my institution—Loyola College—Harry Markopolos alerted the SEC in 1999 that Madoff’s investment success made no mathematical sense. In 2005 he sent a 19-page paper to the SEC titled: “The World's Largest Hedge Fund is a Fraud.” While the document is technical, the fundamental numbers on which it is based are telling. You don’t need a background in forensic accounting to realize what is going on. All you need to do is apply the mediocrity assumption. His reasoning is a classic use of that assumption. Markopolos is quoted as saying:

"No Major League Baseball hitter bats .960, no NFL team has ever gone 96 wins and only 4 losses over a 100-game span, and you can bet everything you own that no money manager is up 96 percent of the months either."

Unfortunately many people bet everything they owned that Madoff could be up 96% of the time.

A few months after I said no to the offer from the “buyer’s club” it closed its doors and its managers disappeared. The local news reported that the State Attorney General was investigating. Many people with “lifetime” memberships prepaid for merchandise they never received. That was 24 years ago. I am still alive. The same techniques for deceiving people are still in use and continue to be effective.

Monday, January 5, 2009

George Santayana’s observation that “Those who cannot remember the past are condemned to repeat it” remains true, but the repeats have been put on fast-forward. For the past year the economy has given me a sense of déjà vu, as if I’ve lived through the past year in another time. In fact, in my early adult life I did live through the events of the past year. It is just that back then—the 1970’s—economic trends took a little longer to play out.

Consider the spectacular rise and subsequent collapse of gasoline prices over the past year. After hitting a high in July 2008 of just over $4 per gallon of regular in the United States, gas prices have fallen to an average near $1.60 as of last week. Similar price action took place before when, in terms of inflation-adjusted 2007 dollars, gas prices went from nearly $2 per gallon in 1978 to over $3 per gallon by 1980. A fall to $1.50 per gallon followed, but it took nearly 5 years. It was not until 1985 that inflation-adjusted gas prices undercut the prices in the late 1970s.

Nominal price and real price in 2007 dollars of a gallon of gas

The causes of the 1970s oil bubble were much the same as ones that caused the 2008 bubble—wars and instability in the mid-east, massive federal deficits that weakened the dollar, trade deficits with other nations.

Then, as now, the economic and political effects of price movements of this magnitude were profound. The price run-up resulted in a severe recession, steep rise in unemployment, depressed stock market, and nationwide disenchantment with its political leadership.

U. S. auto companies had built their business model on selling large gas-guzzlers that suddenly no one wanted. Plummeting auto sales threatened the financial stability of the big three automakers. By 1979, Chrysler Corporation appeared on the verge of bankruptcy. Its chief executive arrived in Washington begging Congress for a bailout in order to save American jobs.

The ruling party in the Whitehouse was decisively voted out of office and a charismatic new president took over, brimming with confidence and optimism and promising change. On February 19, 1981, shortly after taking office, the new president had a question-and-answer session with news editors about his program for economic recovery. He stated in regards to the energy crisis: “The best answer, while conservation is worthy in itself, is to try to make us independent of outside sources to the greatest extent possible for our energy.”

But, when gas prices fell and stock prices rose, the events of the 1970s were quickly forgotten. Everyone resumed their old habits and considered the decade an aberration. Even though no one did anything to solve the underlying problems, no one planned for a repeat of the events of that decade.

It will be interesting to see what happens in the coming year, but I would not become complacent about low gas prices remaining. Oil prices started to rise this week as mid-east fight flared. It is the same war that was fought in the 1940s, and the 1970s being fought today. The same political rhetoric about energy self-sufficiency is coming from the mouths of a new generation of politicians. A new line up of auto company executives beg Congress for bailout money and promise that they have finally learned the lessons of a generation ago.

None of the problems in the 1970s were actually solved or are they being solved now. History repeats itself but this time on fast-forward.

About Me

Joseph Ganem is a professor at Loyola College in Maryland where he teaches physics. He is the author of award-winning book: The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy. The book covers a wide range of topics that touch on on almost all aspects of our consumer lives and shows how numbers are routinely used to fool people.
Among his other interests is chess. He is an expert at correspondence chess and since 1991 has been the editor of The Chess Correspondent, a magazine that has been published by The Correspondence Chess League of America since 1940, making it one of the oldest chess magazines in the United States.
In his spare time he enjoys playing a wide variety of music on the piano. Currently he resides in Baltimore County, Maryland, with his wife and three children.